What is
Hedging?
Hedging is relevant and Important
The Investor
Hedge
Argument
Currency
Diversification
Argument
Stakeholder
Diversification
Argument
Response
from MNCs
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Forms of exchange rate exposure:
transaction exposure,
economic exposure,
translation exposure
Estimate its net cash flows in each currency
Measure the possible effects of its exposure to those currencies
Transaction Exposure
Net Cash-Flow
Currency Portfolio
Measurement of Currency Volatility
Currency
Portfolio &
Risk
Measurement
Currency Volatility over Time
Measurement of Currency
Correlations
Currency Correlation
• Equal amounts of net inflows in two
currencies
What will be MNC’s
exposure in
following cases?
• High correlation
• Moderate correlation
• Negative correlation
• A net inflow in one currency and a net
outflow of about the same amount in
another currency
• High correlation
• Moderate correlation
• Negative correlation
Value added
risk
A related method for assessing exposure
is the value-at-risk method, which
measures the maximum possible loss on
the value of positions held by an MNC
that is exposed to exchange rate
movements
Example – VAR
Celia Co. will receive 10 million Mexican
pesos (MXP) tomorrow as a result of
providing consulting services to a Mexican
firm. It wants to determine, to within a 95
percent confidence level, the maximum oneday loss due to a potential decline in the
peso’s value. Celia estimates the standard
deviation of daily percentage changes of the
Mexican peso to be 1.2 percent over the last
100 days. If these daily percentage changes
are normally distributed, then the maximum
one-day loss is determined by the lower
boundary (the left tail) of a one-tailed
probability distribution, which is about 1.65
standard deviations away from the expected
percentage change in the peso. Assuming an
expected percentage change of 0 percent
(implying no expected change in the peso)
during the next day, then what is the
maximum one-day loss?
VaR to the Transaction
Exposure of a Portfolio
Benou, Inc., a U.S. exporting firm, expects to
receive substantial payments denominated in
Indonesian rupiah and Thai baht in one month.
Based on today’s spot rates, the dollar value of
the funds to be received is estimated at
$600,000 for the rupiah and $400,000 for the
baht. Thus, Benou is exposed to a currency
portfolio weighted 60 percent in rupiah and 40
percent in baht. The company wants to
determine the maximum expected one-month
loss due to a potential decline in the value of
these two currencies (based on a 95 percent
confidence level). Using data for the last 20
months, Benou estimates the standard
deviation of monthly percentage changes to be
7 percent for the rupiah and 8 percent for the
baht; it also estimates a correlation coefficient
of .50 between these two currencies. What is
portfolio’s standard deviation?
ECONOMIC
EXPOSURE
The sensitivity of the firm’s cash flows to
exchange rate movements is referred to
as economic exposure
Impact of
Economic
Exposure
Exposure to Local
Currency Appreciation
Exposure to Local
Currency Depreciation
Economic Exposure of
Domestic Firms
Measuring Economic
Exposure
Economic Exposure to Exchange Rate
Fluctuations
Sensitivity Analysis
Assume that Madison Co. expects
three possible exchange rates for
the Canadian dollar over the period
of concern: $.75, $.80, or $.85.
TRANSLATION
EXPOSURE
The exposure of the MNC’s consolidated
financial statements to exchange rate
fluctuations is known as translation
exposure
the proportion of its business
conducted by foreign subsidiaries
Determinants
of Translation
Exposure
the locations of its foreign subsidiaries
the accounting methods that it uses
Measuring Economic
Exposure
Determine how the costs, revenue, and cash flow items would
be affected by three possible exchange rate scenarios for the
New Zealand dollar (NZ$): (1) NZ$ = $.50, (2) NZ$ = $.55, and
(3) NZ$ = $.60. (Assume U.S. sales will be unaffected by the
exchange rate.) Assume that NZ$ earnings will be remitted to
the U.S. parent.
Value-at-Risk Method
You use today’s spot rate of the Brazilian real
to forecast the spot rate of the real for 1
month ahead. Today’s spot rate is $.4558.
Use the value-at-risk method to determine
the maximum percentage loss of the
Brazilian real over the next month based on a
95 percent confidence level. Use the spot
exchange rates at the end of each of the last
6 months to conduct your analysis. Forecast
the exchange rate that would exist under
these conditions.
•
The economic exposure of British
firms that are heavy exporters to
the eurozone would --------------because------------------------------ .
•
The translation exposure of firms
based in the eurozone that have
British subsidiaries would -------------------------------because -----------------------.
•
The translation exposure of U.S.
firms with British subsidiaries
would ----------because ---------------
Analyse the Impact
The United Kingdom still has its own
currency, the pound. The pound’s
interest rate has historically been
higher than the euro’s interest rate. The
United Kingdom has considered
adopting the euro as its currency. There
have been many arguments about
whether it should do so
•
The economic exposure of U.S. firms
that export to the United Kingdom
and whose only other international
business is importing from firms
based in the euro zone would ----------------------------because ---------------.
•
The earnings of a foreign exchange
department of a British bank that
executes
foreign
exchange
transactions desired by its European
clients would --------------------- because
-------------------------.
•
The British government’s reliance on
monetary policy (as opposed to fiscal
policy) as a means of finetuning the
economy would -----------------because -------------------------- .
Analyse the Impact
The United Kingdom still has its own
currency, the pound. The pound’s
interest rate has historically been
higher than the euro’s interest rate. The
United Kingdom has considered
adopting the euro as its currency. There
have been many arguments about
whether it should do so
•
Assume that the Swiss franc is more highly
correlated with the British pound than with
the euro. A U.S. firm has substantial monthly
exports
to
the
United
Kingdom
denominated in the British currency and
also has substantial monthly imports of
Swiss supplies (denominated in Swiss
francs). The economic exposure of this firm
would --------------------because -------------------------- ..
•
Assume that the Swiss franc is more highly
correlated with the British pound than with
the euro. A U.S. firm has substantial monthly
exports
to
the
United
Kingdom
denominated in the British currency and
also has substantial monthly exports to
Switzerland (denominated in Swiss francs).
The economic exposure of this firm would ---------------------because -----------------------------. .
Analyse the Impact
The United Kingdom still has its own
currency, the pound. The pound’s
interest rate has historically been
higher than the euro’s interest rate. The
United Kingdom has considered
adopting the euro as its currency. There
have been many arguments about
whether it should do so